UNIT-III

Depreciation

Depreciation is the reduction in the value of an asset from wear-and-tear or obsolescence. Depreciation allowance encourages companies to invest in new equipment. For accountants, it gives a proper match of the cost of using the asset to the current revenues by periodic allocation of the original cost to expenses over life of the asset

Methods of depreciation
There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

Straight-line depreciation
Straight-line depreciation is the simplest and most-often-used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life) and will expense a portion of original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value or residual value. Straight-line method:

D epreciation
Depreciation is a fixed business expense. The Internal Revenue Service (IRS) allows businesses to offset the cost of newly acquired tangible assets. Businesses allocate the expenditure over a period of years. A specific dollar amount is allotted each year over the life of the depreciable asset. The cost reduction is depreciation. There are a number of systems the IRS allows for depreciating business assets. Three examples of depreciation methods are straight-line depreciation, decliningbalance method and the sum-of-years' digits method.

Straight-Line Depreciation
A common method of reducing the cost, or purchase price, of assets is straight-line depreciation. This process reduces the cost of an asset by an equal amount each year over the estimated useful life of the asset, typically a number of years. Straight-line depreciation is calculated by dividing the depreciable cost of the asset by the number of years the asset will be used.

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Advantages of Straight-Line Depreciation

is the simplest and most widespread form of depreciation used by businesses . It is suitable for assets that operate uniformly and consistently over the life of the item. The fixed method is straightforward, uncomplicated, easy to understand and simple to apply. Each year the same amount of money is taken as a depreciable business expense on the company's tax return. Straight-line depreciation is suitable for less expensive items, such as furniture, that can be written off within the asset's defined legal, estimated or commercial life. The IRS sets guidelines for estimating an asset's useful life.

Disadvantages of Straight-Line Depreciation

Most pieces of office equipment, machinery and other items purchased do not perform exactly the same each year. As assets age they become less efficient. Repair costs usually increase over time. Straight-line depreciation does not account for the loss of efficiency or the increase in repair expenses over the years and is, therefore, not as suitable for costly assets such as plant and equipment. The functional life span of some assets cannot clearly be estimated. The straight-line depreciation method should not be used when the useful life of an asset is unpredictable.

Read more: Advantages & Disadvantages of Straight-Line Depreciation | eHow.com http://www.ehow.com/info_8649742_advantages-disadvantagesstraightline-depreciation.html#ixzz1jshsjNJQ

For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will

have a salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is thedepreciable cost of the asset divided by the number of years of its useful life. This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation.

book value = original cost accumulated depreciation Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value.

If the vehicle were to be sold and the sales price exceeded the depreciated value (net $17,000 (original cost) $3,000 $3,000 $14,000 book value) then the excess would be considered a gain and $14,000 $3,000 $6,000 $11,000 subject to depreciation recapture. In addition, this gain above the $11,000 $3,000 $9,000 $8,000 depreciated value would be recognized as ordinary income by $8,000 $3,000 $12,000 $5,000 the tax office. If the sales price is ever less than the book $5,000 $3,000 $15,000 $2,000 (scrap value) value, the resulting capital loss is tax deductible. If the sale price were ever more than the original book value, then the gain above the original book value is recognized as a capital gain. If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.

Book value at beginning of year

Depreciation Accumulated expense depreciation

Book value at end of year

Declining-balance method (or Reducing balance method)

Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years are called accelerated depreciation methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. One popular accelerated method is the declining-balance method. Under this method the book value is multiplied by a fixed rate. Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the double-declining-balance method. To illustrate, suppose a business has an asset with $1,000 original cost, $100 salvage value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) 20% per year. With double-declining-balance method, as the name suggests, double that rate, or 40% depreciation rate is used. The table below illustrates the double-decliningbalance method of depreciation.

Book value at beginning of year

Depreciation Depreciation Accumulated rate expense depreciation

Book value at end of year

$1,000 (original cost) 40%

$400

$400

$600

$600

40%

$240

$640

$360

$360

40%

$144

$784

$216

$216

40%

$86.40

$870.40

$129.60

$129.60

$129.60 - $100 $29.60

$900

$100 (scrap value)

When using the double-declining-balance method, the salvage value is not considered in determining the annual depreciation, but the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used. The process continues until the salvage value or the end of the asset's useful life, is reached. In the last year of depreciation a subtraction might be needed in order to prevent book value from falling below estimated Scrap Value. Since double-declining-balance depreciation does not always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life. It is possible to find a rate that would allow for full depreciation by its end of life with the formula:

, where N is the estimated life of the asset (for example, in years).

Activity depreciation
Activity depreciation methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then calculated by multiplying the rate by the actual activity level.

Sum-of-years' digits method

Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than straight line, but less than declining-balance method. Under this method annual depreciation is determined by multiplying the Depreciable Cost by a schedule of fractions. depreciable cost = original cost salvage value book value = original cost accumulated depreciation Example: If an asset has original cost of $1000, a useful life of 5 years and a salvage value of $100, compute its depreciation schedule. First, determine years' digits. Since the asset has useful life of 5 years, the years' digits are: 5, 4, 3, 2, and 1. Next, calculate the sum of the digits. 5+4+3+2+1=15 The sum of the digits can also be determined by using the formula (n2+n)/2 where n is equal to the useful life of the asset. The example would be shown as (52+5)/2=15 Depreciation rates are as follows: 5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year, and 1/15 for the 5th year. Total Book value at Depreciation depreciable beginning of year rate cost

Depreciation expense

Accumulated depreciation

Book value at end of year

$1,000 (original cost)

$900

5/15

$300 ($900 * 5/15)

$300

$700

$700

$900

4/15

$240 ($900 * 4/15)

$540

$460

$460

$900

3/15

$180 ($900 * 3/15)

$720

$280

$280

$900

2/15

$120 ($900 * 2/15)

$840

$160

$160

$900

1/15

$60 ($900 * 1/15) $900

$100 (scrap

value)

Units-of-production depreciation method

Under the units-of-production method, useful life of the asset is expressed in terms of the total number of units expected to be produced:

Suppose, an asset has original cost $70,000, salvage value $10,000, and is expected to produce 6,000 units. Depreciation per unit = ($70,00010,000) / 6,000 = $10 10 actual production will give the depreciation cost of the current year. The table below illustrates the units-of-production depreciation schedule of the asset. Book value at Units of Depreciation Depreciation Accumulated beginning of year production cost per unit expense depreciation Book value at end of year

$70,000 (original cost)

1,000

$10

$10,000

$10,000

$60,000

$60,000

1,100

$10

$11,000

$21,000

$49,000

$49,000

1,200

$10

$12,000

$33,000

$37,000

$37,000

1,300

$10

$13,000

$46,000

$24,000

$24,000

1,400

$10

$14,000

$60,000

$10,000 (scrap value)

Depreciation stops when book value is equal to the scrap value of the asset. In the end, the sum of accumulated depreciation and scrap value equals the original cost.

Units of time depreciation

Units of time depreciation is similar to units of production, and is used for depreciation equipment used in mine or natural resource exploration, or cases where the amount the asset is used is not linear year to year.

A simple example can be given for construction companies, where some equipment is used only for some specific purpose. Depending on the number of projects, the equipment will be used and depreciation charged accordingly.

Group depreciation method

Group depreciation method is used for depreciating multiple-asset accounts using straight-linedepreciation method. Assets must be similar in nature and have approximately the same useful lives. Historical Salvage Depreciable Depreciation Life cost value cost per year

Asset

Computers $5,500

$500

$5,000

$1,000

Composite depreciation method

The composite method is applied to a collection of assets that are not similar, and have different service lives. For example, computers and printers are not similar, but both are part of the office equipment. Depreciation on all assets is determined by using the straight-line-depreciation method. Historical Salvage Depreciable Depreciation Life cost value cost per year

Asset

Computers $5,500

$500

$5,000

$1,000

Printers

$1,000

$100

$ 900

$ 300

Total

$ 6,500

$600

$5,900

4.5 $1,300

Composite life equals the total depreciable cost divided by the total depreciation per year. $5,900 / $1,300 = 4.5 years. Composite depreciation rate equals depreciation per year divided by total historical cost. $1,300 / $6,500 = 0.20 = 20% Depreciation expense equals the composite depreciation rate times the balance in the asset account (historical cost). (0.20 * $6,500) $1,300. Debit depreciation expense and credit accumulated depreciation. When an asset is sold, debit cash for the amount received and credit the asset account for its original cost. Debit the difference between the two to accumulated depreciation. Under the

composite method no gain or loss is recognized on the sale of an asset. Theoretically, this makes sense because the gains and losses from assets sold before and after the composite life will average themselves out. To calculate composite depreciation rate, divide depreciation per year by total historical cost. To calculate depreciation expense, multiply the result by the same total historical cost. The result, not surprisingly, will equal to the total depreciation Per Year again. Common sense requires depreciation expense to be equal to total depreciation per year, without first dividing and then multiplying total depreciation per year by the same number.

Tax depreciation
Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for the production of income. Such deductions are allowed for individuals and companies. Where the assets are consumed currently, the cost may be deducted currently as anexpense or treated as part of cost of goods sold. The cost of assets not currently consumed generally must be deferred and recovered over time, such as through depreciation. Some systems permit full deduction of the cost, at least in part, in the year the assets are acquired. Other systems allow depreciation expense over some life using some depreciation method or percentage. Rules vary highly by country, and may vary within a country based on type of asset or type of taxpayer. Many systems that specify depreciation lives and methods for financial reporting require the same lives and methods be used for tax purposes. Most tax systems provide different rules for real property (buildings, etc.) and personal property (equipment, etc.).

Capital allowances
A common system is to allow a fixed percentage of the cost of depreciable assets to be deducted each year. This is often referred to as acapital allowance, as it is called in United Kingdom. Deductions are permitted to individuals and businesses based on assets placed in service during or before the assessment year. Canada's Capital Cost Allowance are fixed percentages of assets within a class or type of asset. Fixed percentage rates are specified by type of asset. The fixed percentage is multiplied by the tax basis of assets in service to determine the capital allowance deduction. The tax law or regulations of the country specifies these percentages. Capital allowance calculations may be based on the total set of assets, on sets or pools by year (vintage pools) or pools by classes of assets.

Tax lives and methods

Some systems specify lives based on classes of property defined by the tax authority. Canada Revenue Agency specifies numerousclasses based on the type of property and how it is used. Under the United States depreciation system, the Internal Revenue Servicepublishes a detailed guide which includes a table of lives based on types of businesses in which assets are used. The table also incorporates specified lives for certain commonly used assets (e.g., office furniture, computers, automobiles) which override the business use lives. U.S. tax depreciation is computed under the double declining balance method switching to straight line or the straight line method, at the option of the taxpayer.[7] IRS tables specify percentages to apply to the basis of an asset for each year in which it is in service. Depreciation first becomes deductible when an asset is placed in service.

Additional depreciation
Many systems allow an additional deduction for a portion of the cost of depreciable assets acquired in the current tax year. The UK system provides a first year capital allowance of 50,000. In the United States, two such deductions are available. A deduction for the full cost of depreciable tangible personal property is allowed up to $250,000. This deduction is fully phased out for businesses acquiring over $800,000 of such property during the year.[8] In addition, additional first year depreciation of 50% of the cost of most other depreciable tangible personal property is allowed as a deduction.[9] Some other systems have similar first year or accelerated allowances.

Real property
Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use. Many such systems, including the United States and Canada, permit depreciation for real property using only the straight line method, or a small fixed percentage of cost. Generally, no depreciation tax deduction is allowed for bare land. In the United States, residential rental buildings are depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and land improvements over a 15 or 20 year life, all using the straight line method.[10]

Averaging conventions
Depreciation calculations can become complex if done for each asset a business owns. Many systems therefore permit combining assets of a similar type acquired in the same year into a pool. Depreciation is then computed for all assets in the pool as a single calculation. Calculations for such pool must make assumptions regarding the date of acquisition. The United States system allows a taxpayer to use a half year convention for personal property or midmonth convention for real property.[11] Under such a convention, all property of a particular type is considered acquired at the midpoint of the acquisition period. One half of a full period depreciation is allowed in the acquisition period and in the final depreciation period. United States rules require a mid-quarter convention for personal property if more than 40% of the acquisitions for the year are in the final quarter

Objects of Providing Depreciation: a) To Calculate the True Profits: Depreciation is an expense and becomes an important element of the cost of production. Though it is not visible like other expenses and never paid to the outside party yet it is desirable to charge depreciation on fixed assets as these are used for earning purposes; so their depreciation must be deducted out of the income earned from their use in order to calculate true profit net or loss. b) To show true Financial Position: Financial position can be studied from the balance sheet and for the preparation of balance sheet fixed assets are required to be shown at their true value. If assets are shown in the

balance sheet without any charge made for their use or depreciation, then their value must have been overstated in the balance sheet and will not reflect the true financial position of he business. So, for the purpose of reflecting true financial position, it is necessary that depreciation must be deducted from the assets and then at such reduced value these may be shown in the balance sheet. c) To make Provision for replacement of assets: If depreciation is not provided, the profits of the concern will be overstated and can be distributed to the shareholders as dividend. After the end of the working life of the asset, there will be no provision or funds at the disposal of the concern and hos to borrow for purchasing new assets. Provision for depreciation is a charge to profits and loss account though depreciation is not paid. The amount of depreciation accumulated during the working life of the asset provides additional working capital besides providing sum at the end of the working life of the asset for its replacement. Other reasons are d) To have some Incidental advantage e) To have Tax advantage f) To maintain the original monetary investment of the asset intact.